The goal of every value investor is to find undervalued, strong businesses that are likely to grow in value in the long run. Warren Buffett and Charlie Munger’s four filters guide us to purchase “cheap stocks” of good companies that we understand, which have durable competitive advantages and solid managements. While strong analytical, mathematical and financial skills are crucial for investors to develop, critical thinking is just as important and is a skill best developed by studying the liberal arts. I’ll leave the topics of temperament and patience to another day.
The goal of this article is to offer a few tips on how to think critically about the strategic position of companies that you are looking to buy. In his book, "Common Stocks and Uncommon Profits," Philip Fisher highlights 15 questions that can assist us in critically analyzing companies' longer term prospects and provides us with a situational analysis of environment:
1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potential of currently attractive product lines have largely been exploited?
3. How effective are the company's research-and-development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labor and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have depth to its management?
10. How good are the company's cost analysis and accounting controls?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regard to profits?
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?
15. Does the company have a management of unquestionable integrity?
It is obvious that the answers to most of these questions do not lie in the financial statements of the company but in digging deeper into the company filings, other “homework” and giving ourselves the necessary time to think.
Another powerful technique is SWOT analysis. This is a technique that many managers and executives use with success across many industries as a second step in the strategic planning process (immediately after the situational analysis). SWOT Analysis is a method to uncover Strengths, Weaknesses, Opportunities and Threats, which help analyze the business and serve as an indicator for the future prospect of the company. It is a good way to take the focus off temporary excess exuberance for “hot” stocks and, more importantly, to find the discarded, unwanted and unloved stocks that have short-term headwinds but solid long-term prospects.
A simple SWOT analysis that all investors should undertake as part of their fundamental research involves the following components:
· Internal Strengths:
Ø Does the company possess a durable competitive advantage? (I recommend Pat Dorsey’s "The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments" for more on this topic).
· Economies of scale
· Strong brand name
· High switching costs
· Low cost provider
· Barriers to entry
Ø Look at the company’s strengths compared to competitor firms in the industry, the balance sheet and cash flow-generating ability.
Ø The strength of the management team.
Ø The productivity and innovative capacity of research and development activities.
· Internal Weaknesses which include managerial inefficiencies, excessive requirements for capital expenditures, high unionization levels, poor perception regarding the company and its products, weak financials and inability to quickly react to changing market conditions. This is where a lack of a durable competitive advantage, or economic moat, can be identified.
· External Opportunities such as an undiscovered niche, new markets, financial or legal issues of other competitive firms, technological advancements that can be leveraged to enhance operational performance and productivity, and strategic investment/partnership options.
· External Threats which the company could face include financial constraints imposed by external forces such as government regulation, technological advancement adopted by competition, creative destruction from new technologies, introduction of new technology which the company is unable to adopt, pressure by competitors, and macroeconomic pressures.
Think about how this type of critical analysis would have identified the competitive weaknesses of brick and mortar bookstores and the threat imposed by Amazon (AMZN, Financial), the management weaknesses at Enron, and the wild exuberance for the tech sector prior to the dot-com bubble burst. On the whole, the insights that value investors can obtain for themselves by a thorough situational analysis and SWOT analysis can make a huge difference in investment returns. All that it requires is the discipline to carve out time to force yourself to use your best investment tool, your brain.
This approach hits upon three of the four filters; it helps identify a competitive advantage, the quality of management, and, along the way, a critical situational and SWOT analysis brings companies within your circle of competence. Coupled with analysis of the company's operational performance, financial health and subsequent valuation, you can then determine the required margin of safety, set an acquisition price, and patiently wait for the stock to come to you. If you do not have the time, patience, or wherewithal to conduct this type of analysis, you will be better served by a good value-investing fund or an index fund.
The goal of this article is to offer a few tips on how to think critically about the strategic position of companies that you are looking to buy. In his book, "Common Stocks and Uncommon Profits," Philip Fisher highlights 15 questions that can assist us in critically analyzing companies' longer term prospects and provides us with a situational analysis of environment:
1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potential of currently attractive product lines have largely been exploited?
3. How effective are the company's research-and-development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labor and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have depth to its management?
10. How good are the company's cost analysis and accounting controls?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regard to profits?
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?
15. Does the company have a management of unquestionable integrity?
It is obvious that the answers to most of these questions do not lie in the financial statements of the company but in digging deeper into the company filings, other “homework” and giving ourselves the necessary time to think.
Another powerful technique is SWOT analysis. This is a technique that many managers and executives use with success across many industries as a second step in the strategic planning process (immediately after the situational analysis). SWOT Analysis is a method to uncover Strengths, Weaknesses, Opportunities and Threats, which help analyze the business and serve as an indicator for the future prospect of the company. It is a good way to take the focus off temporary excess exuberance for “hot” stocks and, more importantly, to find the discarded, unwanted and unloved stocks that have short-term headwinds but solid long-term prospects.
A simple SWOT analysis that all investors should undertake as part of their fundamental research involves the following components:
· Internal Strengths:
Ø Does the company possess a durable competitive advantage? (I recommend Pat Dorsey’s "The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments" for more on this topic).
· Economies of scale
· Strong brand name
· High switching costs
· Low cost provider
· Barriers to entry
Ø Look at the company’s strengths compared to competitor firms in the industry, the balance sheet and cash flow-generating ability.
Ø The strength of the management team.
Ø The productivity and innovative capacity of research and development activities.
· Internal Weaknesses which include managerial inefficiencies, excessive requirements for capital expenditures, high unionization levels, poor perception regarding the company and its products, weak financials and inability to quickly react to changing market conditions. This is where a lack of a durable competitive advantage, or economic moat, can be identified.
· External Opportunities such as an undiscovered niche, new markets, financial or legal issues of other competitive firms, technological advancements that can be leveraged to enhance operational performance and productivity, and strategic investment/partnership options.
· External Threats which the company could face include financial constraints imposed by external forces such as government regulation, technological advancement adopted by competition, creative destruction from new technologies, introduction of new technology which the company is unable to adopt, pressure by competitors, and macroeconomic pressures.
Think about how this type of critical analysis would have identified the competitive weaknesses of brick and mortar bookstores and the threat imposed by Amazon (AMZN, Financial), the management weaknesses at Enron, and the wild exuberance for the tech sector prior to the dot-com bubble burst. On the whole, the insights that value investors can obtain for themselves by a thorough situational analysis and SWOT analysis can make a huge difference in investment returns. All that it requires is the discipline to carve out time to force yourself to use your best investment tool, your brain.
This approach hits upon three of the four filters; it helps identify a competitive advantage, the quality of management, and, along the way, a critical situational and SWOT analysis brings companies within your circle of competence. Coupled with analysis of the company's operational performance, financial health and subsequent valuation, you can then determine the required margin of safety, set an acquisition price, and patiently wait for the stock to come to you. If you do not have the time, patience, or wherewithal to conduct this type of analysis, you will be better served by a good value-investing fund or an index fund.
